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Marijuana Tax Lessons Learned

Daily Tax Report: State provides authoritative coverage of state
and local tax developments across the 50 U.S. states and the District of
Columbia, tracking legislative and regulatory updates,...

Tax Policy

Recreational marijuana use is currently legal in four states and the District of Columbia,
and on Nov. 8, voters in five others could expand that list even further. In this
article, the Tax Foundation's Joe Henchman discusses tax policy issues inherent in
marijuana legalization.

By Joseph Henchman

Joseph Henchman is the Tax Foundation's vice president of legal and state affairs.

Recreational marijuana use is currently legal in four states and the District of Columbia,
and on Nov. 8, voters in Arizona, California, Maine, Massachusetts, and Nevada could
expand that list even further. Tax policy has been a partial driver of the support,
with states seeking to expand their tax base and raise additional revenue.

Alaska and Oregon legalized marijuana fairly recently, but Colorado and Washington
have been taxing marijuana sales since 2014.
A Tax Foundation report from May 2016 highlights their experience in taxing this newly legal product and offers important
lessons to consider to ensure that marijuana is taxed fairly and effectively. Otherwise,
marijuana tax collections may come in lower than expected and regulatory issues may
catch policymakers off guard.

Be Patient on Revenue Projections

Revenue from marijuana sales in both Washington and Colorado are now growing at levels
beyond what was initially predicted. Based on those figures, states could raise billions
of dollars in revenue combined under a nationwide legalization-and-taxation regime.
But, as Washington discovered, tax collections may grow very slowly at first.

Initially, Washington estimated marijuana taxes could raise nearly $200 million per
year for the first five years. But retail sales in Washington in October 2014 were
only $7 million, though sales for October 2015 did reach $35 million. However, as
of April 2016, marijuana sales in Washington now average over $2 million a day. Sales
at that rate would raise an estimated $270 million per year in excise taxes, far greater
than the $134 million predicted for fiscal 2016. Colorado had a similar experience,
with tax collections jumping from $56 million in the 2014 calendar year to potentially
more than $140 million in 2016.

The potential for significant revenue is there, but it won't happen overnight. Consumers
and businesses will need time to familiarize themselves with the new legal landscape
and regulatory framework.

Keep the Black Market in Mind with Tax Rates, Administrative Costs

Besides sales taxes, marijuana sales are also typically subject to excise taxes. Marijuana
can be sold in a variety of different forms with vastly different concentrations,
so imposing one tax rate on the final retail sales price has proven to be the most
workable solution.

Initially Oregon imposed a “harvest”
tax on marijuana growers, while marijuana flowers were taxed at $35 per ounce, leaves
at $10 per ounce, and immature plants at $5 per ounce. Recognizing the concerns with
enforcing this complex system, legislators replaced it with a 17 percent tax on the
retail price.

Washington previously imposed a 25 percent tax on three stages of distribution: sales
to processors, sales to retailers, retailer sales to customers. This created the possibility
of double taxation and retailers having excise taxes included in their federal gross
adjustable income. The state has since moved to only imposing an excise tax of 37
percent on the final sales price.

States should not only keep in mind the structure of the tax, but also the effective
rate. Excessive taxes could prevent sellers and consumers from moving from the black
and gray market to the regulated economy. Including all state and local taxes, Colorado's
effective tax rate on marijuana is currently 29 percent. By comparison, the tax on
medical marijuana in Colorado is 2.9 percent. A state-sponsored study found that the
retail right kept the black market viable and also discouraged shifting from medical
to retail sales. In response, lawmakers have approved a rate reduction to go into
effect for 2017. Similarly, Washington and Oregon have taken steps to reduce their
marijuana tax rates, with Alaska considering the same. Evidence suggests that initial
rates of 30 percent or more did not reduce the black market sufficiently, and more
recent ballot initiatives propose tax rates of between 10 and 25 percent.

Regulatory Hurdles

As the trend to legalizing recreational use continues, it's worth remembering that
21 states have already authorized the use of marijuana for medical purposes. In general,
medical marijuana is usually more loosely regulated and taxed at a lower level. States
where medical marijuana is already legal need to consider a regulatory structure that
doesn't favor one type over another. Washington, where medical use has been legal
since 1998, encountered this problem. The medical marijuana industry dealt with few,
if any, licensing requirements or production standards and only had to impose the
state's general sales tax. By contrast, recreational sellers faced a number of regulatory
barriers that deterred moving non-medical sales to the retail market. Washington has
since implemented a harmonized regulatory framework covering all marijuana businesses
to address these discrepancies.

Ballot initiatives are driving the legalization push, so policymakers also need to
think about other regulatory issues that may arise after the fact, including rules
on health, agricultural, and zoning. Ballot measures generally don't address such
details, leaving states to resolve issues during the implementation process.

It's hard to ignore the growing number of states seeking to legalize and tax marijuana,
but lawmakers and regulators should plan accordingly to avoid some of the unintended
consequences encountered in Colorado and Washington.

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